What makes a Great International Currency?

What makes a Great International Currency? - Robert A. Mundell

An Epoch-Making Event

The introduction of the Euro in 1999 promises to be one of the greatest events in modern history. It will certainly be the most important change in the international monetary system since President Richard M. Nixon took the dollar off gold in August, 1971, and the system gravitated to flexible exchange rates. But in fact it goes still deeper. The collapse of the Bretton Woods arrangements altered the modus operandus of the international monetary system but it did not change its power configuration. Both before and after the breakdown, the dollar was the dominant currency in the system. The introduction of the Euro, on the other hand, will challenge the status of the dollar in the international monetary system and change the power configuration. For this reason the introduction of the Euro may be the most important development since the dollar replaced the pound sterling as the dominant international currency in World War I.

A decade from now, the international monetary system will look very different. Exactly how different will depend on the importance of the pecking order of currencies and how well the Euro stacks up against the dollar. This article will try to make an assessment.

What makes a currency important internationally? Obviously, confidence in its stability is the key characteristic. But stability is a vector that depends on at least four factors: size of transactions domain; stability of monetary policy; strength of the issuing state; and fallback value. I shall comment on each of these elements before making a general assessment.

Size of Transactions Domain

Size in the sense depth and breadth of the market is a measure of the degree to which a currency can exploit the economies of scale and scope inherent in money as a public good. Size feeds on itself. The larger is the transactions domain, the more liquid the currency. The simplest surrogate for transactions domain is GDP; an alternative measure is the size of the capital market. The size of a single currency area determines its liquidity. Obviously a currency that is money for 100 million people is much more liquid than a currency that is money for one million. Size is also important for a different reason. The larger the single currency area, the better it can act as a cushion against shocks. If you consider a shock such as German unification, manifested in a debt-financed increase in annual government spending and transfers East of more than 150 billion D-marks, close to destabilizing the German economy, then think of the effect of the same shock on a smaller economy. Alternatively, think how much more easily the shock would have been handled had there been in 1992 a stable European currency!

Size is relative. How the Euro will survive depends on the competition. Its two rivals are obviously the dollar and the yen. How such a tri-currency world would work out depends importantly on relative market sizes.

From the standpoint of size, the outlook for the Euro is very favorable. The EU-15 has a population of 375 million, and the EU-11, which includes those countries slated to enter EMU in the first round, contains 292 million, somewhat larger than the United States; by comparison, Japan has 125 million. At current exchange rates, the GDP of the EU 15 is running at the rate of $8.4 trillion, that of the EU-11, at $6.6 trillion. These compare to US GDP running at $8.5 trillion and Japanese GDP $4.1 trillion. All of a sudden, with or without the four countries that will not proceed to the first round, the EU becomes a player on the same scale as the United States and Japan. Overtime, as the other countries join, as the per capital incomes of the poorer members of the EU catch up, and as the EU expands into the rest of Central and Eastern Europe, the EU will have a substantially larger GDP than the United States.

Openness also plays a role because it affects dependence. The less open, the more self-sufficient. As measured by the ratios of exports or imports to GDP, the "G-3" economies are about equally open. Of course the percentage of current exports to GDP in Europe is now around 30%, but when intra-European exports and imports are netted out, the openness figures are remarkably similar. It makes a difference of course whether openness is measured by exports or imports; economies with trade deficits will have higher import than export ratios. The US ratio of imports to GDP is the highest at nearly 11%; the EU 15 and Japan's import ratios are substantially lower at around 8%. With openness measured by exports, on the other hand, Japan's and the EU-15's ratios are around 9%, while the US's is a little over 8%. What emerges from these numbers is a significant fact that the three giant economies are all relatively closed, creating the risk that the monetary authorities may tend to underestimate the importance of the exchange rate and lead to more volatility of exchange rates.

ECB Monetary Policy

The importance of the monetary policy stance scheduled for the EMU countries can hardly be underestimated. No currency has ever survived as an international currency with a high rate of inflation. The lower the rate of inflation, the lower the cost of holding money balances, and the more of them will be held. In addition to a low rate of inflation a stable rate is also desirable; because, however, inflation and variance go hand-in-hand, much of the problem is avoided if inflation is kept low.

Additional considerations are predictability and consistency in monetary policy. In a democracy both are abetted by transparency. If the monetary authorities openly state their targets and their strategies for achieving them, the market and the critical public will be able to make its own judgement about inflation outcomes.

From the standpoint of sound monetary policy, the outlook for the Euro is also very favorable. The Maastricht Treaty is unambiguous in making price stability the target of monetary policy; while the ECB can and should assist the monetary union in carrying out its other objectives, it is forbidden to do so if such assistance would conflict with price stability. Monetary policy will not be used to reduce unemployment by "surprise inflation" or to inflate away embarrassing public debts.

There remains considerable discretion for the independent ECB. They will have to determine how price stability can best be achieved. The problem is complicated by lags in the effect of monetary policy. The best approach for a large economy like the EU is to target the inflation rate, formulating monetary policy actions on forecasts of inflationary pressures. Leading indicators that should alw ays be taken into account include gold prices, other commodity prices, rates of change in the different monetary aggregates, the growth rate and bond prices. The most successful central bankers have been pragmatists. But there is no reason why an independent ECB, modeled partly after the Bundesbank, cannot be as effective a body as the Federal Reserve System in the United States or the Bank of Japan. As Otto Pohl once said, "credibility is the capital stock of any central bank," and you can be sure that the management of the ECB will do its best to establish credibility at the outset.

The Security Factor

Monetary stability of course depends on monetary policy. But monetary policy is in tum affected by its sine qua non, political stability. Strong international currencies have always been linked to strong central states in their ascendancy. The reason is not far to seek. When a state collapses, the currency goes up in smoke. Examples include the hyperinflation of Germany and a few other countries after World War I; the collapse  of the ruble after the October 1917 Revolution; the hyperinflation of Kuomintang China after the communist forces of Mao Tse-Tung crossed the Yang-Tse; and the hyperinflation in the former Yugoslavia in the 1990s. It does not bode well for its currency if a state is not powerful enough to defend itself against enemies from outside and within.

What about the Euro and the EU? Is the EU a strong central state? It is here that one can see a potential weakness of the Euro. Of course we could simply assume universal peace and go on to the next syllogism! If our assumption proved to be correct, the EU would not have to worry about enemies from without. It would be sufficient to hold itself together. Yet even here, nothing can be completely taken for granted. Monetary union is supposed to be irrevocable. But it might not be in the face of a violent economic crisis. A real test would be its ability to hold itself together in the face of a drastic terms-of-trade shock such as that experienced in the 1970s when oil prices quadrupled.

The problems arising from the weakness of the central state cannot be swept under the rug. However, there are strong mitigating factors. The Cold War ended, putting aside what was in the post-war years the most dangerous threat to European security. A closely connected factor is NATO, probably the most successful alliance in history. As long as the EU is tied to NATO and the military alliance with the United States, the EU will be able to fend off enemies from without even if it is not a strong central state. At the same time, the process of monetary union will itself be a catalyst for political union, quickly bringing to common attention the most fissiparous issues. These factors greatly mitigate what would otherwise be a fatal defect.

The Fall-Back Factor

Historical analogies can be treacherous. Modern currencies differ from the great currencies of the past, which were all either gold or silver, or convertible into one or both of those metals. Unlike paper currencies, they had a fall-back value if the state collapsed. If any of the Italian city-states coining the sequins, florins or ducats of the Middle Ages collapsed, the 3.5 gram gold content would always have a fall-back value in metal. Metallic currencies frequently outlive the state issuing them, as the flourishing of Macedonian states in the centuries after Alexander's death clearly attest. A more recent example is the Maria Theresa thaler which continued to circulate in Eastern Africa long after that lady and the Austro-Hungarian empire was no more. That does not hold for a paper currency. After the Battle of Gettysburg in the United States, Confederate notes became worthless.

Until the advent of the dollar, there is no historical record of any fiat currency achieving great international significance. Before the twentieth century all the great international currencies were metallic. The predecessor of the dollar, the pound sterling, achieved its great distinction as a metallic currency. Even the dollar achieved international importance as a gold currency, selected unofficially as the anchor at Bretton Woods; if the dollar is now fiat currency, as a "ghost of gold" it is the exception that makes the rule.

The introduction of the SDR provides an illustration of the fall-back factor. When first distributed in 1970, it had a gold weight guarantee confirmed in the Second Amendment to the Articles of Agreement of the IMF. The gold guarantee made it a substitute for gold rather than the dollar and, at a time when gold was under-priced, a coveted asset that was in great demand. After the dollar was taken off gold, however, the international monetary authorities reneged on the gold guarantee, and the SDR went through a series of transformations, ultimately turning into a five-currency basket. When the Euro comes into existence and the mark and franc and perhaps also the pound are scrapped, the SDR will have to be changed again. Had its gold guarantee been maintained, however, the SDR would have been much more important in the international monetary system and perhaps qualified as a useful supra-national unit of account. Lacking both a commodity fall-back value and the backing of a strong state, the SDR fell by the wayside on the scrap-heap of forgotten dreams.

There is in this a lesson for the Euro. In any great political emergency, and especially one that threatened the durability of the EU, there would be a run on the Euro that would not be mitigated by any fall-back value. A run or even the risk of a run would make it difficult to float long-term securities in Euros.

It might be argued against this, that economies like Germany's thrived even when it was on the front-line of the Cold War. Yet two factors need to be understood. The first was the existence of NATO which kept Germany under the security umbrella of the United States. The second was that Germany, like most of the other countries on the European continent, did not - or only rarely - issued debt exceeding 10-15 years. The substantial issues of long-term securities have been a phenomenon of the post-Cold War world.

Such an emergency of course might also weaken the dollar. Total political and military security can never be assumed. Nevertheless, the US situation differs in that the dollar has an established reputation; the US, though a federation, has a strong central government; and it is a military superpower. The lesson in this for the Euro is that the ECSB will need larger holdings of external reserves than otherwise or than the United States. Fortunately, the EU countries have dollars and gold in abundance and will therefore be able to meet any foreseeable contingency.

General Assessment

All things considered, the Euro should stand up very well. It has two great strengths: a large and expanding transactions size and a culture of stability surrounding the ECB in Frankfurt. Initially, the EU-11 will be smaller than the dollar area, but as other members enter, as the EU expands, and as the poorer countries catch up, the Euro area will eventually be larger than the dollar area. From the standpoint of monetary policies, there is also not much to choose between the two areas. Information is globally mobile and there is no reason why the ECB should not become as efficient as the Federal Reserve System in the United States.

The Euro also has two weaknesses: it is not backed by a central state and it has no fall-back value. These weaknesses would be enormously important in an unstable world. At present, however, we are in a period of remarkable stability. The Pax Americana backed up by NATO has been just as efficient in preventing major conflicts as the Pax Britannica of the last century. For the foreseeable future, we should bet on stability rather than the opposite and that tends to neutralize the absence of political union in the EU. At the same time, the more than substantial EU gold and currency reserves will compensate for the fact that the Euro starts out with no fall-back commodity value. Together, membership in NATO and large reserves suffice to neutralize what would otherwise be fatal defects.

Robert Alexander Mundell is 1997-8 AGIP Professor of International Economics at the Johns Hopkins University School of Advanced International Studies Bologna Center and Professor of Economics at Columbia University. He is currently working on a book on the history of the international monetary system. His latest publication was Inflation and Growth in China (1996). In 1996, he was elected distinguished fellow of the American Economic Association.